Dolby headphone technology is a way of getting pseudo surround sound out of standard headphones. By using encoding algorithms to vary the waveform of the music, the ear can be tricked into thinking the sound is coming from somewhere different, in spacial terms, than it actually is.

How so? Well, your ear determines where the location of the sound is by examining the small differences in waveforms as they arrive. By faking those small differences in the waveform itself, the surround effect can be achieved.